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Mitigating Risk with Independent Contractors

Article contributed by Volt Workforce Solutions, June 2010

Short-Term Savings, Long-Term Concerns
Many companies hold the belief that hiring independent contractors instead of employees provides "All of the benefits without all of the costs." It is speculated that this misconception has fueled the usage of independent contractors in almost every business and industry. Because independent contractors are not added to the company payroll, some companies have assumed that they have realized savings with respect to employer paid social security taxes, employee benefits, unemployment payments, profit sharing, workers’ compensation premiums, and more. Furthermore, some companies have seemingly found it less problematic to end an independent contractor relationship, rather than terminating an employee’s employment. This serious misunderstanding of the law has posed significant and extraordinarily costly risks to business entities.


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Companies that reduced their in-house employee workforce, in favor of retaining independent contractors (often called 1099 workers for the Internal Revenue Service (IRS) form issued to reflect their yearly compensation), seeking a perceived cost-saving measure, may have created a serious liability. Neither the hiring company nor the independent contractor can simply decide to designate an individual as a 1099 independent contractor without regard to the IRS classification factors which define an independent contractor. Parties cannot simply sign a written contract that states an individual is an independent contractor and make it so.

Employee misclassification can lead to legal challenges of all sorts. The IRS routinely examines the classification of independent contractors and if they find that an independent contractor has been misclassified and should, in reality, have been an employee, the ramifications can be severe. It can certainly result in being forced to pay the taxes of the misclassified employees and may also carry associated penalties. It is much easier for the IRS to collect unpaid back taxes and penalties from a hiring company rather than chase every misclassified independent contractor who failed to report the income. It is the hiring company’s responsibility to classify the individual correctly and it is the hiring company that will likely pay dearly for misclassification.

The independent contractors themselves, even after enjoying the benefit of being paid gross compensation from the company instead of receiving a pay check, may nonetheless later claim they were actually performing and being managed like employees. With that line of thinking, they should therefore be eligible for the health and welfare benefits granted to the company’s other employees, entitled to workers’ compensation or due unemployment pay, for example. Over the last 20 years, there have been a variety of investigations and lawsuits related to workers who were called independent contractors, but nonetheless served in employee roles. This has resulted in the payment of unpaid back taxes and/or benefits expenditures amounting to hundreds of millions of dollars by the hiring company, specifically due to misclassification issues.

Employee vs. Independent Contractor
Determining whether a worker is an employee or an independent contractor depends largely on the nature of the work and how it is to be performed, not on what the written contract says. There is no black and white test that does not involve some potential for subjective interpretation of the facts and circumstances to distinguish an employee from an independent contractor. Published IRS guidance has grouped certain factors which are to be considered in order to analyze whether a person and project meets the qualifications to be an independent contractor. These factors or tests have been described in three categories for purposes of assessing whether a worker is actually an independent contractor or an employee:
  • Behavioral: Does the company control or have the right to control what the worker does and how they do their job?
  • Financial: Are the business aspects of the worker’s job controlled by the payer? (how the worker is paid, expense reimbursement, who provides tools/supplies, etc.)
  • Type of Relationship: Are there written contracts or employee type benefits? Will the relationship continue and is the work performed a key aspect of the business?
The key to a successful 1099 independent contractor program is to make sure every step of your classification analysis will stand up to scrutiny. Review the IRS classification guidelines posted at www.irs.gov, particularly the following IRS published articles, which may be especially enlightening:

http://www.irs.gov/businesses/small/article/0,,id=99921,00.html

http://www.irs.gov/newsroom/article/0,,id=173423,00.html

http://www.irs.gov/taxtopics/tc762.html

http://www.gao.gov/new.items/d09717.pdf

Protection Starts with Preparation
While each employer/contractor relationship is different, there are multiple subject areas to be considered. An examination of both the position or nature of the task to be performed, as well as whether the person identified to fill the role may be viewed as an independent contractor, may factor into the analysis of the classification. Examples of some of the subject areas which may be considered are as follows:
  • Can the nature of the work to be performed be stated in a clear and specific agreement that identifies expected deliverables, dates and dollar amounts of a project?
  • Is a job description, rather than a product deliverable statement of work, more appropriate?
  • Is the independent contractor a corporation or limited liability company with an established place of business and other clients?
  • Does the independent contractor have significant insurance coverage?
  • Where is the work to be performed and on whose timetable?

Common Flags of Potential Worker Misclassification
While the assessment is different for each independent contractor, there may be several circumstances that could trigger an IRS audit or investigation of your independent contractor classifications, such as:

  • The hiring company once used W-2 employees for the same work now done by 1099 independent contractors
  • Both a 1099 and W-2 form are issued to the same individual's social security number for the same calendar year, by the same hiring company/employer
  • One hiring company provides the independent contractor's sole source of income

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Identify Misclassification Risks and Solutions
According to the Bureau of Labor Statistics, over 10 million American workers are classified as independent contractors. Companies that understand the challenges of utilizing and properly classifying independent contractors will gain the most advantage from those workers and avoid costly misclassification errors. Many businesses have embraced payroll service or referred employee programs to better manage their labor workforce, including the classification of their independent contractors. A staffing agency can provide a broad pallet of options to educate and rectify employee classifications on a go forward basis. Additionally, an agency can assist your company in identifying potential problem areas and propose possible solutions.

Rely on Resources You Trust
Successful deployment of independent contractors depends on understanding the benefits, risks and rules. For more information on effective employee management and other workforce strategies, please contact Mark Zolikoff at mzolikoff@volt.com or visit www.volt.com.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (I) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) that may be addressed herein.

This memorandum is for the marketing of certain services by Volt and is a summary for general information, provided for informational purposes only. It is not a full analysis of the matters presented. In addition, it is not intended to provide, be construed as, or to constitute legal advice. Legal advice of any nature should be sought from your own legal counsel.

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